The Fox Sports 1 End Run

Launching a new network isn’t about tackling ESPN. News Corp. rewrote its playbook to escape the blitz of rising sports costs

Fox Sports 1 will lend some much-needed muscle to News Corp.’s sports coverage and earnings growth. But while Murdoch & Co.’s grand plan appears to have come together almost perfectly, there was a larger game of chess going on than many investors realized. By the time News Corp. announced in March its intent to launch a rival 24-hour sports network to ESPN, the company had already spent enormous amounts of money locking up major sports rights including MLB, NASCAR, NFL and NCAA college basketball. If chief operating officer Chase Carey hadn’t found some way to put those rights to better use, paying for them would have significantly slowed the company’s margin expansion. That, in turn, could have affected the company’s share price, and its current plan to buy back a good chunk of its stock.

(From the pages of the April 9 issue of Variety. Article by David Bank, Senior Equity Media Analyst, RBC Capital Markets; Edited by Rachel Abrams.)

Under the terms of its recently renewed agreements, News Corp. has committed to spending $4 billion for MLB rights over eight years, $2.4 billion for NASCAR over eight years and $9.9 billion for the NFL over the nine years. It also spent many millions more in other commitments for college basketball and other rights. RBC estimates that the pricetags overall rose an average of 7.6% year-over-year for five-year deals running through 2017 for all rights buyers.

What was not totally apparent, however, was that as News Corp. was paying more for those rights, it had a backdoor plan for how to monetize them. But it had to obtain content stealthily, so as not to tip its hand too early. If the company announced FS1 before it had all the sports rights it needed, that could have driven up the rights costs and gotten other companies with 24-hour sports networks to bid more aggressively.

But the goal here is to build an attractive business that consumers want, not to beat ESPN. Carey has stated that an FS1 launch could expand the category, and that there is room in the business for another player.

Some observers have suggested that News Corp. could have broadcast its sports content on one of its other networks like FX, which has already proven successful. But that wouldn’t have made much sense given that strategy would have displaced much of the current programming Weeks after the FS1 announcement, News Corp. moved to expand the FX brand with plans to transform Fox Soccer Channel into FXX in September.

Similarly, another News Corp. cable channel, Speed, is being converted into FS1 by August. There’s also the possibility of an FS2 and FS3 being launched in the future.

While Speed currently reaches 81.4 million subs, that number should hit 90 million by the time FS1 launches with NASCAR, college football and basketball, UFC, rugby and soccer in its lineup. Regular-season and post-season MLB will join FS1 next year.

While that may not be quite an ESPN-caliber programming lineup, RBC estimates it will be enough to increase the subscription fee from 22¢ per subscriber per month to $1. That would boost affiliate revenues from $215 million to $1.08 billion.

Generating that growth was crucial considering the increases News Corp. is facing in sports rights. The company had $1.6 billion in sports rights costs on its balance sheet in 2012, and that’s not including another $1.4 billion in unidentified rights costs for its regional sports networks. That $1.6 billion could grow to $2.8 billion by 2017, while the RSN costs could reach $2.2 billion the same year. Increases to MLB and NFL rights account for most of it, as did the Super Bowl, which Fox will be airing in 2014 and 2017. News Corp. had spent a ton of money locking up national rights. As a result, if it didn’t move on FS1, it would have been in a far less healthy position.

But with FS1 in place, RBC estimates News Corp.’s affliate revenue could grow 14% from 2014, when it reaches $7.5 billion, to $8.5 billion in 2015, instead of growing by just 10% to $8.2 billion without the benefit of FS1. RBC’s projected addition of just over $1 billion in affliate revenue over 2012-17 from FS1 could mean achieving expansion of 4.3% in blended EBITDA margin of cable networks and television segments combined between 2014 and 2017 — instead of just 0.8% growth without FS1.

Just look at the projected growth rate for cable and TV segments EBITDA in 2017 vs. the prior year: 6% without FS1, but nearly double that amount with FS1 added (11.6%).

The implications for the company’s stock are signifi cant here. Slowed margin growth could have limited News Corp.’s ability to repurchase stock, especially if the company was underperforming compared to its peer group.

News Corp. is one of many conglomerates in the midst of aggressive stock repurchases. The buybacks increase investor dividends, and News Corp. completed a $5 billion stock repurchase last year. Shortly thereafter, the company announced its intention to repurchase another $5 billion. But News Corp.’s planned split from its publishing division has slowed the pace of that buyback substantially. RBC is anticipating a return of capital to investors somewhere in the $4 billion range annually.

These circumstances added an impetus for News Corp. to launch FS1 when it did, as the company would likely not have wanted to slow down the pace of its share repurchase agenda further.

News Corp.’s margin expansions through FS1 could also help the company to take its leverage up higher, thereby executing a more favorable and shareholder-friendly capital allocation strategy (as opposed to a broader mergers and acquisitions strategy).

FS1 underscores how News Corp., like many of the conglomerates, is really essentially a cable-channel company. Pre-spinoff News Corp.’s cable business represented approximately 60% of overall EBITDA. Of that 60%, sports is probably 35%. People don’t think of News Corp. as a sports channel company, but in a large way, it really is.

Disclosure: David Bank, the author of this article, is a research analyst at RBC Capital Markets, LLC (member FINRA, NYSE, SIPC). This article summarizes or otherwise incorporates material that the author has previously published in research reports dated as of March 8, 2013, and Feb. 4, 2013, that were provided to both eligible clients of and internal personnel at RBC Capital Markets, LLC. The information contained in this article is current only as of such date(s) Conflicts Disclosures: The analyst(s) responsible for preparing this research report received compensation that is based upon various factors, including total revenues of the member companies of RBC Capital Markets and its affiliates, a portion of which are or have been generated by investment banking activities of the member companies of RBC Capital Markets and its affiliates. RBC Capital Markets, LLC makes a market in the securities of News Corporation and may act as principal with regard to sales or purchases of this security. The author is employed by RBC Capital Markets, LLC, a securities broker-dealer with principal offices located in New York, USA. Analyst Certification: All of the views expressed in this report accurately reflect the personal views of the responsible analyst(s) about any and all of the subject securities or issuers. No part of the compensation of the responsible analyst(s) named herein is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the responsible analyst(s) in this report.

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